New Tracking Stock Offers Cheap Play on VMware

The newly created tracking stock for VMware that will be issued by Dell as part of its $58 billion deal to buy EMC looks like a cheap way for investors to play VMware.

Shares of the tracking stock, Dell Technologies Class V (ticker: DVMTV), have been trading in the when-issued market for about two weeks and now changes hands at $44.68, roughly a 39% discount to VMware’s (VMW) common shares, now fetching $73.33. VMware is a software company best known for its virtualization products.

The VMware tracked shares are being issued to EMC (EMC) holders as part of Dell’s cash-and-stock acquisition of EMC. Dell announced yesterday that the deal received Chinese regulatory approval, the last hurdle to the transaction, and will close on Wed. Sept. 7. The ticker on the tracker will change to DVMT after the deal closes.

EMC holders will receive $24.05 in cash and 0.111 shares of the VMware tracker for each EMC share. EMC shares are fetching $28.99 today, unchanged on the day. Investors also can play the VMware tracker by purchasing EMC shares since they will get the tracker once the deal closes next week.

Dell offered the tracker as part of the consideration for the EMC deal in order to give EMC holders continued exposure to the company and reduce the cash outlay for the deal. EMC owns about 80% of VMware.

Tracking stocks, which are designed to reflect the economic performance of the underlying company, typically trade at some discount to the regular stock but the discount on the VMware tracker is unusually wide. Liberty Media’s tracking stock for SiriusXM Holding (LSXMA) now trades at $33.51, an estimated 12% discount to Sirius stock (SIRI). Investors understandably prefer to directly own shares in a company rather than a tracker.

Barron’s wrote earlier this month that EMC was an attractive arbitrage situation because of the effective discount being applied to the VMware tracker. At that time, EMC traded at $28.20.

At a price of $44.68 on the tracker, investors effectively are purchasing VMware at just 10 times estimated 2016 earnings of about $4.30 a share, and that doesn’t reflect the company’s $16 a share in net cash.

Why such a steep discount on the tracker? The shares will be a class of Dell common stock and thus be exposed to the credit risk of Dell, which will be highly leveraged following its purchase of EMC. If Dell fails, the tracker could be wiped out. While Dell will be a junk-grade company following the EMC deal with estimated debt to annual cash flow of about six, it will have a sizable amount of annual cash flow and plans to deleverage. Another issue is that investors are wary about Dell CEO Michael Dell’s intentions. While Dell is bullish on VMware, it conceivably could let VMware languish under its control to repurchase the tracker stock or VMware itself more cheaply down the road.

One sizable EMC holder says he sees several reasons why the tracker discount to VMware could narrow. For starters, it’s rumored that some big institutional investors may be ready to purchase the tracker as an alternative to VMware once the deal closes.

The tracker apparently is more liquid than VMware and likely will get even more so once the deal closes. There will be about 223 million shares of the tracker outstanding, more than double the roughly 80 million shares of VMware. Dell will hold the remaining VMware stock, a roughly 28% stake. The higher liquidity in the tracker could narrow the discount.

While Dell is expected to focus initially on paying down debt, it could be a buyer of the tracking stock and indeed has stated publicly that it “may look for opportunities to repurchase shares” of the tracker, or Class V common.

What’s the upside in the tracker? If the tracker discount narrows to 25%, the shares would trade around $55 — about 23% above the current price — assuming no change in VMware.

A spinoff of Dell’s VMware stake to tracker holders in a one-for-one share swap isn’t likely for five years because of adverse tax consequences, according to New York tax expert Robert Willens. Such a move would collapse the tracker/VMware spread. Even without that event, tracker investors still could score if the discount narrows.